The Kenyan Parliament has just passed a new Finance Bill and there is one important piece of good news: interest rates will not be capped.
Prior to this, there was the risk that Kenya would embrace unconventional economic policies, and there was heated debate regarding price controls over the last months.
Many policy makers and Kenyans think that interest rates ought to be capped at a certain level, especially following a sharp rise since the end of 2011.
People are affected by high prices, and inflation has only started to come down over the last few months.
The debate on price controls reminded me of Germany in the 1980s. At that time, my country was still split in two. While West Germany followed a “social market economy”, East Germany opted for a state-led model in line with Soviet and communist philosophies.
One core economic policy of the East was price controls on all possible goods. Food, rent and services all had fixed prices. Also, the currency was set at parity with West Germany’s “Deutsche mark”. But this exchange rate was unrealistic, given West Germany’s success and East Germany’s relative stagnation.
In May 1989, I went on a high school trip to the East — a special treat at that time because access was limited and highly regulated. We were approached by black market traders offering a ratio of 5:1. You probably remember what happened in the six months following my trip: The Eastern bloc collapsed and the Berlin Wall came down.
Travelling through Africa in the 1990s, I had many similar experiences: many goods were scarce, and the black market was vibrant.
Economists may not know a lot but, as Nobel Prize winner Milton Friedman put it: “We do know how to create a shortage”. Price ceilings are the easiest way to create one.
Evidence around the world demonstrates that attempts to control prices often lead to higher prices (in a parallel market). And the hardest hit are the poor!
Any interest rate ceiling means credit has to be rationed. In that case, there is no guarantee that the most productive investment receives the credit.
Often, credit is rationed on political grounds, which undermines investment productivity. Worse still, banks which give out these politically-charged loans are often not repaid.
So how can price rises be avoided and poor families protected? Aren’t banks charging disproportionate fees and benefiting from high interest rates?
The frustration vis-à-vis some banks is understandable. They seem to be making large profits in times when others are having a hard time. I also never understood why I needed to pay a large sum of money each month just to have my bank manage my money.
In most countries, you add to your savings each month because banks pay interest on your deposits. However, most Kenyans seem to be losing out as many banks charge higher fees than the interest.
Reforms are clearly needed to protect Kenya’s consumers. But don’t kill the goose that lays the golden eggs! A strong economy needs strong and liquid banks.
Many global companies consider Nairobi their hub and entry point for Africa, not least because of Kenya’s strong services, including banking.
Over the last few weeks, the main area of contention has been the “interest rate spread” which is the difference between the interest the bank charges you for a loan (“lending rate”); and the money they give you for keeping your money with them (“savings rate”).
For about a year, Kenya’s spread has been above 10 percentage points, and with higher overall interest rates, it can become very expensive to borrow.
However, the “spread” is not equivalent to the bank’s profits. A large share of the banks’ income is spent on operational costs, which are higher for banks with a presence in rural and remote regions.
What can Kenya do to reduce interest rates and keep the financial sector strong?
First, try to bring down inflation further. Food remains the key driver of inflation, and better food policies would help.
Second, Kenya has a strong reputation for sound macroeconomic policies and a strong financial sector. But you still need strong institutions which make sure that there is a level playing field for firms to compete.
A key concern is the slow implementation of regulations to address the flow of illicit funds. If Kenya continues to make limited progress, it risks weakening the reputation of its financial system, prompting enhanced scrutiny on all financial transactions, and increasing their costs in the country.
Third, competition and innovation are the best medicine against high prices. The telecoms sector has demonstrated that prices can come down dramatically if well-regulated competition unfolds.
If the banking sector follows the model of telecoms, Kenya could get the best of both worlds: A stable financial system and cheaper loans!
Note: This contribution follows on John Zutt’s (World Bank Kenya Country Director) commentary on interest rate controls in March 2012, and builds on the work by the World Bank’s financial sector and economic teams.
Wolfgang Fengler is the Lead Economist for the World Bank in Kenya. His blogs can be found in https://blogs.worldbank.org/africacan/team/wolfgang-fengler. Follow Wolfgang Fengler on Twitter: www.twitter.com/ @wolfgangfengler